Federal Reserve System Key Roles

Federal Reserve System

Key Roles of the Federal Reserve and its Structure

Federal Reserve (also called Fed for short) is the country's Central Bank that performs several key roles in the functioning of the economy such as conducting the country's monetary policy, supervision and regulation of its banking system, and issuance of the national currency.

The Fed structure consists of seven members of the Board of Governors, a Federal Open Market Committee (FOMC), twelve regional Federal Reserve District Banks, and their member banks. At the top of the structure is the Board of Governors, appointed by the President, with the advice and consent of the Senate. The Board is headed by its Chairman, who is also appointed by the President from among the 7 Governors. The FOMC consists of the seven members of the Board of Governors and five representatives selected from the Federal Reserve Banks. The twelve, privately-owned regional Federal Reserve Banks are located in major cities throughout the country; each Bank covering a designated "District." At the base of the Fed structure are the member commercial banks, which consist of all federally chartered banks. (Johannes, 2006)

How the Federal Reserve Implements the Monetary Policy

Managing the monetary policy is Fed's most important function, which it does through control of the money supply and availability of credit in the economy. In times of recession the Fed attempts to increase the money supply and in times of inflation it tries to decrease it. Open Market Operations is the tool most often used by the Fed to affect the supply of money in the financial markets by the buying and selling of government securities and bonds on the open market. When there is a slow-down in the money supply, the Fed purchases Treasury securities from the open market. This injects cash into the financial system, and has the affect of expanding bank reserves and lowering of the federal funds rate. It also enables banks to loan more money and helps the economy grow faster. On the other hand, when the money supply is growing too rapidly and interest rates are lower than desired, the Fed sells government securities in the open market; thus taking money out of circulation, causing interest rates to rise and making borrowing more difficult. It can also affect the money supply by changing the required reserve ratio, i.e., the percentage of cash deposits that banks must maintain as reserve at the Federal Reserve banks. A lower reserve requirement allows banks to make more loans and increases the money supply. Conversely, a higher reserve requirement reduces the amount of loans banks can make, which tightens the money supply. The Fed can also increase or decrease the money supply into the economy by changing the interest rate (discount rate) it charges banks when they borrow money from the Federal Reserve System. Lower discount rates encourage borrowing by banks, increasing the nation's money supply and vice versa. ("What are the Tools..." 2006)

Impact of Fed's Actions During the Last 20 Years

The main objectives of the Federal Reserve System during the last 20 years and more have been to ensure maximum employment (and output), stable prices, and moderate interest rates; these objectives, having been specifically included in the Federal Reserve Act through an amendment, in 1977. During most of the last 20 years (from August 1987 to January 2006), the Fed was headed by Alan Greenspan whose personal economic philosophy to a large extent guided the Fed's actions. One of the features of the Federal Reserve's "accommodative" policies was encouraging low interest rates, which was partly responsible for the longest period of economic expansion in U.S. history in the 1990s.

Assessment of the Efficacy of the Fed's Actions

The impact of all actions by the Fed during the last 20 years has not been without controversy. Encouraging of historic low interest rates and increased liquidity during much of the nineties, while contributing to a "feel good" wealth factor, has also been responsible for an unprecedented "housing bubble" in the U.S. that is currently threatening to burst. The Fed's over-enthusiastic support of the Bush administration's tax-cut policies has also contributed to the biggest current accounts deficit in the country's history. Similarly, although the Fed's role in the handling of the 1987 Stock Market Crash was praise-worthy, it seemed to have done little to prevent the technology stocks-led Stock Market bubble at the end of 1990s.

Appropriate Actions for the Fed in 2006

The Fed has held benchmark interest rates steady at 5.25% for its past three meetings. Although the latest manufacturing index for November 2006 shows its lowest level for three years prompting predictions for a slow-down in the U.S. economic growth in the fourth quarter of 2006, concerns about high core inflation also remain (Schneiderman, 2006). Such inflation concerns as indicated in recent speeches by the Fed Chairman, in my opinion, preclude any significant interest rate cuts by the Fed in the near future, while further hikes in interest rates are also unlikely; hence interest rates are expected to remain steady for sometime, at least until mid of next year.